Variation in Option Returns : The Importance of Moneyness, Maturity and Skewness

This paper examines the differences in average options returns for a variety of option maturities. A simulation which assumes that the returns in the underlying asset are normally distributed and that options are priced according to Black-Scholes produces average returns which are positive and decreasing in the time to maturity for Call options of all moneyness levels and negative and increasing in the time to maturity for Put options of all moneyness levels. However, a simulation based on actual S&P 500 Index returns, which include a sub-period of high, positively skewed returns ("bull" market) and a sub-period of lower negatively skewed returns ("bear" market), produces some different results. Specifically, short-dated out-the-money (OTM) Calls exhibit negative average returns in the bull market, and Calls of all maturities deliver negative average returns in the bear market. Long-dated Put options deliver positive average returns in the bear market. I conclude with some empirical work on actual option prices, which must be interpreted with caution because of the illiquidity in all but the shortest-dated at-the-money options. The empirical evidence suggests short-dated OTM Calls actually produced positive returns in the bull market because of relative underpricing consistent with the well-known implied volatility skew